Friday, October 10, 2008

The current financial crisis is only the beginning

By James Saft

Reuters

Thursday, October 9, 2008

CHARLESTON, South Carolina: Yes, Virginia, the banking crisis will one day end, but what comes after promises to be even more arduous.

With the solvency of the Western banking system seriously in question, there is a temptation to hope that if only the latest bold, last-ditch rescue plan will work, we can go back to the good old days of 2006.

One could argue that the banking crisis is just the cold sweat, not the flu that follows it.

The problem is not just that the banking system has been broken by an orgy of foolish lending but moreover that huge swaths of the global economy are predicated on that foolish lending and the consumption it allowed.

The bubble wasn't just in real estate, leaving the financial system holding the bag; the bubble was in consumption.

That is not to say that the current scrambling to save the system is pointless. There is a very big difference in the damage that would be done by a disorderly deleveraging compared with a slightly slower, more controlled one.

The banking crisis will have very serious negative effects on the real economy, and the cost will grow. This is true even if ATM machines continue working, our deposits stay safe, and gold, bullets, canned goods and bottled water don't become the best asset allocation choices for 2008.

The core of the issue isn't even solvency. It's the way in which the debt causing the banking insolvency distorted, distended and hollowed out economies around the world.

It caused a huge misallocation in the English-speaking economies into real estate, and into consumption that could only seem to make sense to people drunk on the appreciation of property prices. It caused a less huge but still significant misallocation elsewhere; I think we will see that a lot of what was being produced by Europe and Asia's vibrant export industries were products that the United States and Britain will find they can do without, or with much less of.

Don't get me wrong: The banking crisis is extraordinarily dangerous. But the changes in the global economy that are needed are even more profound. Savings rates are going to need to rise in the developed economies of the English-speaking world, and consumption fall. Those economies are also going to have to place a higher priority on producing goods and services they can sell abroad.

There are lots of parts of the "service economy" that very likely won't exist in two years time, or only in a very feeble way. Take for example the U.S. and British phenomenon of late-middle-aged people setting up small service businesses after they have been laid off from their jobs. Very often they use a combination of their severance package plus equity extracted from their houses to provide themselves with working capital, and often to supplement their earnings.

So, someone who - for the purposes of argument - used to work for IBM in the Hudson Valley in New York State starts a business installing marble countertops. For four of the last six years that has been a good business, but the people paying for it were only able and willing to do it so long as the illusion that consumption-is-investment could be maintained.

That is over, and significant parts of the U.S. economy will need to be repurposed, and will need to do so at a time when we are suffering from asset-price deflation and may well get deflation. The recession will be long and probably ugly.

Just think about your own lives and the people you know: How many of them do jobs that didn't exist 15 years ago but have nothing, really, to do with new technology? Many of those jobs are enjoyable and worthwhile offshoots of a credit bubble and will have a very difficult time surviving its demise.

Similarly, it will be tough for those English-speaking economies' global enablers. China will need to find somewhere else to sell many of its goods. The grand bargain of China buying U.S. Treasury bonds to finance consumption in the United States will come under enormous and dangerous strain.

Europe, too, as well as other exporters, will hit difficulties - not just in their banking systems, which helped finance the binge, but also in their auto and consumer electronic industries, just to name two.

There is no doubt that the needed changes can happen and that these innovative and creative economies can re-balance. But it is going to be very painful.

"We have before us the opportunity to forge for ourselves and for future generations a new world order, a world where the rule of law, not the rule of the jungle, governs the conduct of nations. When we are successful, and we will be, we have a real chance at this new world order, an order in which a credible United Nations can use its peacekeeping role to fulfill the promise and vision of the U.N.'s founders." - President George Bush 1991

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“We shall have World Government, whether or not we like it. The only question is whether World Government will be achieved by conquest or consent.” – James Paul Warburg, whose family co-founded the Federal Reserve - while speaking before the United States Senate, February 17, 1950

"For two centuries we've done the hard work of freedom. And tonight we lead the world in facing down a threat to decency and humanity. What is at stake is more than one small country, it is a big idea - a new world order, where diverse nations are drawn together in common cause to achieve the universal aspirations of mankind: peace and security, freedom, and the rule of law. Such is a world worthy of our struggle, and worthy of our children's future." - PresidentGeorgeBushState of the Union Address 1991

"A really efficient totalitarian state would be one in which the all-powerful executive of political bosses and their army of managers control a population of slaves who do not have to be coerced, because they love their servitude. To make them love it is the task assigned, in present-day totalitarian states, to ministries of propaganda, newspaper editors and schoolteachers.... The greatest triumphs of propaganda have been accomplished, not by doing something, but by refraining from doing. Great is truth, but still greater, from a practical point of view, is silence about truth." - Aldous Huxley Brave New World foreword to 1946 edition